Hedge Funds: An Industry Overview

EZRA ZASK
The Journal of Alternative Investments 2000.3.3:33-42. Downloaded from www.iijournals.com by Ezra Zask on 12/03/09. It is illegal to make unauthorized copies of this article, forward to an unauthorized user or to post electronically without Publisher permission.

EZRA ZASK is a managing director of Berkshire Capital in New York, NY.

n the past decade the hedge fund universe has grown from a small number of firms managing several hundred million dollars to 6,100 hedge funds that now manage $355 billion.1 If we add “traditional” alternative investments, a category including distressed securities, leveraged buyout (LBO) funds and private equity, the assets under management for all alternative investments rise to well over $500 billion. Alternative investments have become an important part of the portfolio of many investors, especially high net worth individuals, endowments, and foundations.2 Despite this dramatic growth, hedge funds remain largely peripheral compared to mutual funds and institutional investment managers. Spectacular and well-publicized losses such as the $426 million loss by Manhattan Capital Management and the $3.6 billion bailout of Long-Term Capital Management (LTCM) serve as a deterrent to many potential investors, especially pension funds that have fiduciary responsibilities. In recent years some of the industry’s most well-known performers, such as George Soros and Julian Robertson, have turned in uneven and highly volatile results, with the latter choosing to exit the business. Moreover, the lack of transparency and liquidity and the absence of regulatory oversight have contributed to a limited role for hedge funds in the past. Finally, the absence of commonly accepted hedge fund evaluation benchmarks, at least until recently, has been an issue for many potential investors.

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Recent trends have led observers to speculate that the hedge fund universe is reaching a critical consolidation and institutionalization phase paralleling the mutual fund and institutional fund manager consolidation in previous decades. Traditional asset managers (banks, mutual funds, venture capital firms, insurance companies and institutional investment managers) have become more active in providing their clients with alternative investment strategies. Other contributing factors are increased self-regulation of hedge funds, in the wake of the LTCM; growth in hedge fund investments by endowments, foundations, and pension plan sponsors; the development of hedge fund performance indexes and risk management strategies; the proliferation of Internet sites for alternative investments; and the recent dramatic increase in the number of hedge funds being organized. About 2,000 new hedge funds were created in 1999 alone, according to Tremont Advisers, Inc., a hedge fund consulting firm, raising the total number of hedge funds to more than 6,000. In this article the trends and their implications for the alternative investment area, especially regarding the key issues of increased use of alternative investments by traditional institutional investors, the structure and ownership of the industry, the changing relationship between private equity and hedge funds, and the issues involved in the valuation of hedge funds are examined. 33

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THE JOURNAL OF ALTERNATIVE INVESTMENTS

event-driven. forward to an unauthorized user or to post electronically without Publisher permission. market-neutral. In fact. macro. announced it planned to invest up to $11. which provides the Managed Account Report’s typology of hedge funds along with the definition of their trading strategies. High net worth investors account for the majority of hedge fund assets. limited partnership) and both have relatively low correlations with traditional stock and bond market investments. a doubling of their 25% market share today. enabling them to protect assets during market downturns. . Last year. distressed securities. with institutional investors making up just 25% of funds. Hedge funds are now commonly defined by their structure. a number of issues may limit the increased commitment to hedge funds by institutional investors. This no longer necessarily serves to distinguish hedge funds since certain mutual funds and traditional asset managers may also take short positions.4 However. have also been preempted by traditional fund managers and. compared to only 5% that were invested in bonds and 4. The arguments for common treatment are that they share a similar organizational structure (i. fixed income securities or commodities.S. [1999]). On the other hand. the fund principals have their own capital at risk in addition to funds raised from clients.. may be more widely used by investors in the future. especially the market-neutral investment managers. arbitrage. there are significant differences.3.3% of their assets in alternative investments including private equity. private equity firms may well acquire existing hedge funds or start their own. Nearly one-half of these funds were entirely invested in equities.7 trillion will come from institutional investors. Downloaded from www. primarily in equities. Private equity assets are sourced primarily from institutions and are substantially less liquid than most hedge funds. Alternative asset class investments by pension funds. Two other hedge funds traits. These funds generally charge a performance fee on top of a management fee. the majority of hedge funds are now long-only or long equity bias funds in equities. and derivative instruments. with the increased use of indexed products. Because many hedge funds are organized as offshore vehicles or have fewer than 499 limited partners. endowments and other institutional investors seeking portfolio diversification and higher returns have grown steadily over the last several years. First. as the investment focuses of many hedge funds and private equity funds are converging on high technology investing and the Internet.iijournals. hedge funds typically were able to take short as well as long positions. the assets managed by hedge funds will increase from approximately $355 billion today to $1.e. Hedge funds have evolved to encompass a wide range of styles including trend-following. the largest U. Despite these differences. PRIVATE EQUITY AS ALTERNATIVE INVESTMENT There is some disagreement as to whether hedge funds and traditional private equity investments (venture 34 HEDGE FUNDS: AN INDUSTRY OVERVIEW capital. Meanwhile. If the private equity investment segment continues its exponential growth (see Exhibit 2). The wide diversity of investment strategies subsumed under the hedge fund rubric is indicated by Exhibit 1 below.25 billion in hedge fund and other hybrid investments. and LBOs. Finally.3:33-42. we believe that private equity investments and hedge funds will become more closely aligned in the future and that any analysis of hedge funds should therefore consider the private equity universe as well. It is illegal to make unauthorized copies of this article. the giant California Public Employees Retirement System Fund (Calpers).com by Ezra Zask on 12/03/09.8% in futures and derivatives (Cerulli and Associates. investing in nontraded equity and debt infusions rather than publicly traded stocks. investments in private equity. pension fund. This wide range of markets and instruments and the relative lack of correlation of some hedge funds with traditional investments and popular indexes have increased their attractiveness as a source of diversification in investment portfolios. in most if not all hedge funds.7 trillion in 2005. Because private equity is more solidly entrenched with institutional investors than hedge funds. At least half of this $1. the former may help the latter with institutional clients. Non-profit institutions now have 7. over 50% of European pension funds recently indicated that they would be invested in alternative investments in the near future. By one estimate. The most pressing concerns are 1) periodic dramatic losses and WINTER 2000 The Journal of Alternative Investments 2000. and mergers and acquisition investment programs) should be jointly considered as alternative investments. the use of leverage and derivatives. They are private investment pools organized as limited partnerships or limited liability corporations with the investment manager as general partner and investors as limited partners.3 One of the key questions for the future growth of the alternative investment industry is the extent to which institutional investors will allocate a greater share of their assets to hedge funds. according to a recent report. they are largely free of government regulations. relative value. bonds.INDUSTRY OVERVIEW Hedge funds were once differentiated from traditional investment management firms by several traits. LBO.

Allocates capital to a variety of fund types. 2) the extreme fragmentation of alternative investments firms. SEGMENTATION OF THE HEDGE FUND UNIVERSE Sector ShortSellers outright fraud that stem from the lack of transparency and regulation of the hedge fund industry and from unexpected market movements. overseas investors. Global Global Macro Long-Only Leveraged Market-Neutral Niche Allocates capital to one specific type of fund. worth individuals..g. The classic Soros-Steinhardt-Robertson type hedge fund using leverage and derivatives to enhance positions. etc. Established U. Downloaded from www. a part of the hedge funds industry is consolidating around a relatively small number of large players that are well defined by a group of identifiable trading styles. high-tech. The fund-of-funds and investment consultants who have recently helped create usable performance benchmarks and identify and steer investments into a select group of hedge funds and commodity trading advisers (CTAs) have also aided the consolidation of the industry by channeling funds to the larger and more established managers. Emerging Usually focus on specific regions. International Bottom-up-oriented equity investments around the world (except U. With a reasonable track record. Manager buys bonds and goes short instruments that replicate the owned bond. A hedge fund borrows stock and sells it. However. A single trader or group of traders can. Subtype Distressed Securities Risk Arbitrage Diversified Comment/ Description Securities of companies in reorganization and/or bankruptcy. Traditional equity fund with leverage and incentive fee.com by Ezra Zask on 12/03/09.EXHIBIT 1 Hedge Fund Types Style EventDriven Fund of Funds The Journal of Alternative Investments 2000. Follows economic sectors and/or industries (e. hoping to buy it back at a lower price. It is illegal to make unauthorized copies of this article.). European. how hedge funds are following mutual funds and institutional investment managers toward industry concentration and institutionalization is described. The economics of the industry facilitate this fragmentation. endowments. RegionalFocuses on opportunities in established markets (i. it seems unlikely that we will see an end to the proliferation of new hedge funds in the near future.6 Because there are thousands of potential investors in hedge funds and barriers to entry are extremely low. In the following discussion. Fund buys stock in a company being acquired and sells stock in its acquirers.S. Long/Short Convertible Arbitrage Stock Arbitrage Fixed income Arbitrage Allocations on the long and short sides of the market. INDUSTRY STRUCTURE AND ORGANIZATION Similar to the worlds of mutual funds and investment managers. 35 THE JOURNAL OF ALTERNATIVE INVESTMENTS . Fund buys a basket of stocks and sells short stock index futures contract.3.). and foundations.iijournals. and smaller institutions. or reverse. the hedge fund universe is likely to become segmented along two lines. A number of private equity investment pools have already started to build their businesses with the objective of servicing institutional clients. these hedge fund managers can do moderately well with assets under management of only $25 million.. RegionalManager invests in less mature financial markets. at the same time.S. Manager goes long convertible securities and short underlying equities. largecap.e. Other obstacles to wider acceptance of alternative investment include the high performance fees charged by fund managers and their resulting motivation to “swing for the fences” and maximize investment return by increasing leverage or assuming riskier positions. with relatively small start-up cost and low overhead. which makes gathering information difficult and costly. become profitable with an asset base of as little as $10 million.. in large part because of the intrinsic independence of the typical hedge fund manager. The other will become dominated by a smaller number of large players that direct their activities to the larger institutional marketplace—the pension fund plan sponsors. and 3) the lack of widely accepted performance and style benchmarks to help impose consistency.3:33-42. and Japanese).5 One area of the universe will continue to be fragmented as it is geared toward high net WINTER 2000 The hedge fund universe has always been fragmented. forward to an unauthorized user or to post electronically without Publisher permission. family trusts.

com by Ezra Zask on 12/03/09. Caldwell & Orkin. the 6.5 38. Asset Alliance Corporation manages $1.) A number of mutual funds now offer hedge funds. offer diversified trading. TRADITIONAL INVESTMENT MANAGEMENT FIRMS Traditional investment companies and financial institutions (mutual funds.S. . The earliest such fund was Barr Rosenberg’s Market-Neutral Fund. and. Given the recent experience of highly leveraged hedge funds. has invested in a number of hedge funds.000 hedge funds follow the 80/20 rule. The most prevalent direction of institutional movement into the hedge fund realm has been towards equity “marketneutral” (or “statistical arbitrage”) funds that most closely resemble the original hedge fund structures of the 1950s. Gabelli Capital Management. The top firms tend to be larger and better organized. institutional asset managers. (emerging market).7 Other institutional investment managers have similarly begun to move into products offering traditional hedge-fund-like strategies. incentive compensation. Strong Capital Management. Thus they can only leverage up to 1/3 of their equity. have longer track records. most importantly. Heartland. partly due to their high visibility. in which a small number of firms tend to dominate.3:33-42. diversification from traditional investment vehicles. The barriers to entry into this select group of money managers are higher. which dictated that mutual funds can’t derive more than 30% of their profits from short-term trading and short selling. improved systems. within their range of investments.1 29. requiring an identifiable brand name. Many pension funds and consultants will not invest in a fund with a shorter track record. personal counselors and private banks) have been developing alternative investment programs. may be more transparent and better understood by their clients. including Galtere International (distressed debt). We believe that offering an alternative investment program will become increasingly important for asset management companies targeting institutional investors and high net worth individuals. Vanguard Company and Wellington Management. sometimes described as “hedge fund lite.6 1995 1996 1997 1998 1999 2000 Source: Private Equity Analyst.P.5 95. this limitation may actually help mutual funds by preventing the excess that has proven to be the downfall of many hedge fund managers. a $300 million fund that uses warrants and options and holds short positions. and L. (However. Private Equity Funds (in $billions) 140 120 100 80 60 40 20 0 115 92. Munder Capital Management and Key Asset Management are planning to add hedge funds to their portfolios in the near future. Capital Z Investments. especially sector and market-neutral funds. the Euclid Mutual Funds’ Market-Neutral Fund and Montgomery Global Long Short. Other examples include the Value Line Hedged Opportunity Fund.2 61. significant funds under management. and CDC’s MPT+ Funds. and decision makers. Downloaded from www. Alliance Capital has a total of 13 hedge funds. Institutional Investors and Alternative Investments. setting the stage for increased competition in this area in the future. 1999. OneWorld Investments L. mutual funds are still required to have 300% coverage on debt. As in mutual funds. Capital Partners. Other mutual funds and investment management companies have developed hybrids of hedge funds and mutual funds.2 billion through eight hedge funds: BeaWINTER 2000 The Journal of Alternative Investments 2000.” These include funds managed by Montgomery Capital Management.EXHIBIT 2 New Commitments to U. It is illegal to make unauthorized copies of this article. multiple managers.3. A number of institutional firms have pursued acquisition strategies to increase their menu of client offerings or for investment purposes. as does State Street Global Advisors. and risk management. AIM. attracted by their high fees. State Street Research.C. Gartmore Investment Management has two pooled hedge funds (one focused on European shares and the other on bonds and currencies). The ability of mutual funds to offer hedge fund programs was made possible by the Securities and Exchange 36 HEDGE FUNDS: AN INDUSTRY OVERVIEW Commission’s removal of the short-short rule. including the Alliance Select Investor Series Premier Portfolio.iijournals. forward to an unauthorized user or to post electronically without Publisher permission. The Alliance Premier Portfolio has achieved an annualized 49% investment return over five years and its management fee is pegged to fund performance. personnel and systems infrastructure and. bankowned asset management firms. and ability to help retain top money managers. Franklin Templeton. linked to Zurich Financial Services Group. a verifiable track record of at least three and preferably five years.

Source: Evaluation Associates Capital Markets. First Union. are the volatility of hedge fund earnings and the resulting difficulty of valuing hedge funds and the “independent” personalities of many hedge fund managers.3 4. Of course. an affiliate of Value Asset Management Inc. a convertible arbitrage hedge fund while Mesirow raised $250 million to provide start-up and investment capital to hedge funds. Bank of America.com by Ezra Zask on 12/03/09. to service its high net worth clients. as in the case of Long Term Capital Management.3 -6. Bank of America and Toronto Dominion are only a few of the major banks that offer these programs to investors. and the nascent development of hedge fund “supermarkets. part of its alternative investment program. A growing number of banks offer a range of alternative investment programs for their high net worth individual client bases. Milestone Global Advisors. indicative of the continuing strong interest of individuals in this product area. Ltd.7 41. Pacific Assets Management. JMG Capital Management. Morgan Stanley Dean Witter and Merrill Lynch have longstanding fund-of-fund programs for retail and institutional investors.7 27. especially in the United Kingdom. Grosvenor.EXHIBIT 3 Hedge Fund Results 1999 Hedge Fund Type Evaluation Associates Capital Markets Index (EACP) Relative Value Long/Short Equity Convertible Hedge Bond Hedge Multi-Strategy Event Driven Deal Arbitrage Bankruptcy/Distressed Multi-Strategy Equity Hedge Funds Domestic Long Biased Domestic Opportunity Global/International Global Asset Allocators Discretionary Systematic Short Selling S&P 500 Composite Percentage Change: 1999 23. “style drift. while Deutsche Bank manages hedge funds as WINTER 2000 Key concerns of institutional investors contemplating a hedge fund investment have been transparency and risk management. TRANSPARENCY AND RISK MANAGEMENT con Hill Asset Management. legislative. such as pension funds. mutual funds. and an obstacle to further consolidation through institutional ownership.5% 13. occurs more frequently than desired. Bricoleur Capital Management.3 14. there is a trend towards ownership of hedge funds by syndicates.” in which a hedge fund’s investments fall outside their stated investment style. Among brokers. that have a fiduciary responsibility. resulting in improvements in the transparency and risk management practices of the leading hedge funds. SunTrust Banks announced it will begin to offer hedge fund products to its clients via Alpha Investment Management.0 67.7 19. investors are concerned with excessive leveraging. Credit Suisse Asset Management has recently added Credit Suisse Prime Select Strategies.7 16.3:33-42. as do European banks. France and Germany.1 8. Several other banks also have hedge fund programs in development. and NationsBank. Because most hedge fund prospectuses allow their managers a wide latitude in investment instruments and strategies.2 15.iijournals.3 15. industry and banking.3. Silverado Capital Management.0 -1. Citicorp. a hedge fund fund-of-funds. and Hedge Funds Services (BVI).. Chase.5 2. forward to an unauthorized user or to post electronically without Publisher permission. Morgan Stanley Dean Witter’s Wealth Management Services acquired Graystone Wealth Management Services to advise high net worth clients on hedge fund investments. investment managers and insurance companies. Trust Advisors.8 68. Most recently. On the negative side.0% The Journal of Alternative Investments 2000. while Goldman Sachs purchased Hull Securities to provide fund-of-funds expertise to its high net worth clients. This lack of transparency makes hedge fund investments especially difficult for institutions. These concerns are being dealt with at a number of levels: regulatory. We believe that transparency will improve in the future as a result of THE JOURNAL OF ALTERNATIVE INVESTMENTS 37 . Finally. The fact that hedge funds are largely unregulated makes it difficult for investors to gain information on their strategies and positions.1 58. CDC has a large-scale internally managed hedge fund specializing in mortgage-backed securities. North American banks including Citicorp. Downloaded from www.” The attractions of hedge fund ownership include their high fees and theoretically lower correlation to traditional investments than other financial vehicles. In addition. the largest bank alternative investment vehicles are the venture capital funds managed by Chase. invested $50 million in Sagamore.5 16.5 21. It is illegal to make unauthorized copies of this article.

pressure from important investors. disclose their leveraging. setting up many funds for larger than anticipated losses as volatility returns. The Risk Control Division of Bear Stearns Securities Corporation. including loan limits and improved information on investment risk. allowing a level of scrutiny not previously available. none of these risk management strategies are able to do more than extend the recent past into the future. Unfortunately. and Goldman Sachs have all undertaken this role for clients. The Bear Stearns Risk Analytic Control System stress tests hedge fund portfolios across 200 hypothetical market scenarios and highlights results from the point of view of liquidity. international associations. More than a dozen websites now provide investors with information on hedge fund and private equity performance. asset size. and the Internet’s relentless spotlight. Even if passed. government and regulatory bodies. Congress and Federal Reserve Board have also increased pressure and threatened regulation of brokers (and hedge funds) to improve their monitoring of hedge fund risk and exposure. unknown to some of its creditors. where transparency and risk management practices are more fully developed and taken for granted. Many of these managers came out of traditional 38 HEDGE FUNDS: AN INDUSTRY OVERVIEW investment management organizations. Congress and the investment community. and concentration in specific markets. The President’s Working Group (a joint Treasury Department and Federal Reserve Board group) has issued its own recommendations on hedge fund regulation. Increasing professionalization of the hedge fund industry has also led to greater transparency and improved risk management practices. There is no doubt that banks and brokers have been less willing to extend credit (the ultimate source of leverage for hedge funds) without extensive due diligence. RISK MANAGEMENT The Journal of Alternative Investments 2000. security risk. as their importance increases along with the assets they manage. may have surpassed $200 billion. U. Another development that promises improved transparency for hedge fund investors is the growing number of Internet sites that have begun reporting on hedge fund performance. Separately. and control the risk of their market positions. banks and brokers have become increasingly vigilant about their hedge fund exposure.S. There are an increasing number of fund managers who have experienced at least two financial crises and have track records that exceed five years. forward to an unauthorized user or to post electronically without Publisher permission. and may soon pass. credit providers (i. and portfolio optimization. the Basel Committee on Banking Supervision (part of the Bank for International Settlements) proposed new standards for “highly leveraged institutions” (hedge funds). and crises continue to occur. In recent years. for example. government regulators. and market risk. the Capital Markets Subcommittee of the House of Representatives has debated. We are convinced that this trend will only accelerate in the future and prove to be an important source of hedge fund transparency. we believe that some form of regulation will be inevitable. scenario analyses. In fact. has developed a tool that allows hedge fund managers to demonstrate to clients how the fund’s portfolio would respond under different market or interest rate scenarios. Bear Stearns. Downloaded from www. and risks. use of derivatives. the legislation raises the bar so high that relatively few hedge funds will be impacted. WINTER 2000 . Morgan Stanley. in which 12 institutions put up $3.iijournals. Hedge fund managers have come under the same pressure as all financial institutions to measure. At least two hedge fund Internet sites report daily NAVs for a growing number of funds. The result has been the widespread adoption of state-of-the art risk management techniques such as Value-at-Risk9 and Monte Carlo simulations.3. It is illegal to make unauthorized copies of this article. One trend worth noting is the growing link between pension funds and prime brokers in which the brokers collect information for their pension fund clients on hedge funds’ positions. It seems likely that the hedge fund community will continue to suffer from over-leveraging as market volatility declines in the near term.625 billion to rescue a fund whose market exposure. Following the Long Term Capital Management bailout..com by Ezra Zask on 12/03/09. Standard & Poor’s has started a service with Ernst & Young that tracks the actual positions of funds and evaluates their risk in normal markets and financial crises. banks and brokers).e. The Securities and Exchange Commission. communicate.3:33-42. regulation that would require hedge funds with assets over $3 billion or that are part of a family with over $20 billion in assets under management to provide detailed financial information every quarter.8 This pressure comes from a variety of sources: clients. especially those that deviate substantially from recent events.10 REGULATION AND LEGISLATION Government regulation and legislation are a constant threat to the hedge funds’ status as stateless entities and their sometimes-visible role in relatively small and illiquid markets. stress testing. making them less useful for anticipating future developments.

global established. a track record not achieved by many managers. It is illegal to make unauthorized copies of this article. As a result of the first and second factors. This has been made clear over the past four years when few hedge funds were able to beat the stock market indexes. and portfolio benefits of hedge funds. the literature shows widespread disagreement regarding the performance. In a more modest approach. as we point out below. and for persons who own and invest on a discretionary basis at least $25 million in investments (on their own or others’ behalf) if each beneficial owner of the company’s securities is a qualified purchaser. This raises the possibility of the development of baskets of traditional stock and bond instruments that may replicate the performance of hedge funds at substantially lower costs and with much greater transparency. which has allowed the development of benchmarks and indexes for alternative investments. as an asset class. While hedge fund volatility has been a long-standing argument against these products. In fact. second. One important result of these initiatives (and the LTCM losses) has already been seen: banks are markedly less willing to provide capital to hedge funds to increase their leverage. Martin [1998] has conducted an extensive analysis of the relationship between hedge fund and CTA returns and the volatility of these returns. Additionally. volatility. The evidence here is that the hedge fund universe has begun to develop standardized trading styles and results. While hedge funds outperform passive benchmarks over several up and down cycles. this diversification benefit has decreased in recent years with the increase of the number of hedge funds that are primarily long stocks and bonds. However. hedge funds and commodities trading advisors have been shown to reduce the volatility of an investment portfolio composed only of stocks and bonds. Most analysts conclude that alternative investments. finally. for family companies with $5 million in investments.The Journal of Alternative Investments 2000. and short equity. the returns and risks of these hedge fund groupings are sensitive to underlying economic indicators. the wide variety of styles and types of hedge fund makes generalizations difficult.iijournals. analysis by Barra indicates that it takes 16 years of data to conclude that an active investment manager is actually in the top quartile of results. The results show that alternative investments do indeed cluster into eight groupings (or styles): managed futures. they are unlikely to outperform passive benchmark indexes for shorter periods as when the indexes are well above their long-term historical average. “Improving Counterparty Risk Management. event-driven. hedge funds sometimes change styles without notification. issuing their own report. notably bond and stock market returns and swap spreads (spreads between government and corporate bonds indicating market perception of interest rate risk). the “survivorship bias” in most hedge fund performance data overstates average annualized returns by 2% or more. Before the most recent debacles.” since the choice of style explains THE JOURNAL OF ALTERNATIVE INVESTMENTS 39 . This Act also provided for new exemptions for qualified individual purchasers with $5 million in investments.3:33-42. emerging market Asia. These changes effectively increased the number of hedge funds and investors that would be exempt from government regulation in marked contrast to the trends described above that seek to increase government regulation. A full statistical analysis of this issue is beyond the scope of this article. forward to an unauthorized user or to post electronically without Publisher permission. the 1997 National Securities Market Improvement Act (3)(c) (7) raised investment pool limits from 99 investors to 499. A key finding of Martin’s analysis is that “the benefits of proper style selection outweigh the returns to manager selection. STATISTICAL RESULTS: PORTFOLIO AND INVESTMENT DIVERSIFICATION The analytical argument for investing in hedge funds must address four factors: first. market arbitrage. the increased volatility of stocks and bonds (and their increased correlation to each other both domestically and internationally) has made the traditional volatility of hedge funds less of a negative factor than in the past. For example. Hedge funds offer diversification benefits to portfolios otherwise consisting WINTER 2000 only of traditional bonds and stocks because of the less than perfect correlation to major market movements. We therefore limit ourselves to a few points related to the factors above. because of their ability to go short.11 By some estimates. Downloaded from www. although performance varies widely by hedge fund style and methodology.3. unsuccessful hedge funds tend to go out of business and are not included in most analyses.” in June 1999.12 One key consideration in the development of hedge fund indexes is the extent to which hedge funds actually do trade along a number of definable styles that are consistent over time. In addition.com by Ezra Zask on 12/03/09. third. long equity. emerging market Latin America. hedge funds can theoretically provide at least a partial hedge against declining stock markets. style consistency. have a role to play in diversified investment portfolios. twelve Wall Street firms sought to establish a code of practice for banks and securities firms on how the market extends credit to leveraged positions.

40 HEDGE FUNDS: AN INDUSTRY OVERVIEW The Internet appears to be poised to change the alternative investment universe as it has all other aspects of finance. A large number of funds are. Downloaded from www. the true source of concern about the alternative investment universe should be its excessive reliance on a bull market in stocks and bonds and on the easy money that has been responsible for its growth and development. the returns of the hedge fund community over the past year indicate that this is not a common strategy. Investors may not mind paying 1/20 during a bull market.iijournals.3. many nonequity funds are correlated with stock market movements through the interest rate. especially private equity. swaps and commodity markets. As hedge fund sites proliferate. In general.com. In addition. equity hedge funds. HEDGE FUNDS AND THE INTERNET While the headlines go to LTCM and Princeton Economics. regulatory agencies. Their projected plans would.com. Its goal is to become the industry standard for hedge fund performance measurement. are also linked to a continued bull stock market. if successful. some farseeing hedge fund managers may consider monetizing some of their new-found prosperity through a partial or full sale of their operation prior to any stock market correction. The Internet is becoming an increasingly important information delivery and e-commerce channel in the alternative investment industry. based on the CSFB/Tremont Hedge Fund Index. HedgeWorld Limited (a Bermuda-based provider of online services to the hedge fund industry) has joined the Bermuda Stock Exchange of Hamilton to create the HedgeTrust Exchange. Of course.The Journal of Alternative Investments 2000. It is illegal to make unauthorized copies of this article. we expect that the fees charged by hedge funds (especially the incentive fees) will come under increasing pressure from institutional investors. Even more discouraging from a diversification standpoint. Exhibit 3 reinforces this conclusion.S. But what happens if hedge funds do not hedge—that is. However. This pressure will accelerate further if alternative investment (hedge fund and private equity) performance falters during a sustained correction in the stock or bond markets. which are predominantly taking long (and sometimes leveraged) positions in stocks. more of the differences in hedge fund performance than the particular hedge fund manager one chooses within each style.3:33-42. Another alternative for these managers is to hedge their clients’ assets against a stock market downturn.. Many expect that Internet-related developments in the hedge fund universe will result in heightened regulatory scrutiny with respect to access to fund information by qualified investors and limitations on hedge fund marketing over the Internet. price competition and standardization in the hedge fund world. This may also be used in the future to counter the hedge fund managers’ argument that they deserve a 1% management fee and 20% incentive fee. protect their assets during bear markets? It seems likely that investors will demand lower fees and reduce their hedge fund investments. who as a group are extremely fee-sensitive. By making hedge fund information accessible to more investors.S. which is partially owned by Tremont Advisers Inc. FITX Group Limited and Putnam Lovell.com. at base. 63% of the return generated by international hedge funds was accounted for by movement in the S&P 500. it appears inevitable that the Internet will promote greater transparency. an asset-weighted index that includes nine sub-indexes. and Plusfunds. at least at present. showing that the strong performance of hedge funds in 1999—their return was greater than the S&P 500 for the first time in four years—came almost entirely from equity hedge funds. Finally. marketing over the Internet will likely draw increased attention from U. This leads us to conclude that the alternative investment universe is heavily dependent on a continued bull equity market for their strong performance and asset growth. mirroring its impact in the brokerage industry.com by Ezra Zask on 12/03/09. forward to an unauthorized user or to post electronically without Publisher permission. declines in the stock market are accompanied by widening spreads in the interest rate markets. the “traditional” alternative investment areas. In a related development. Hedgefundnet. dependent on a bull market. including market-neutral funds. the first regulated WINTER 2000 . revolutionize the hedge fund industry. Three Internet sites are especially important for their comprehensive coverage of the hedge fund universe and also for their innovative features: Hedgeworld. During periods of global financial shock. SOURCES OF HEDGE FUND PERFORMANCE while a bear market threatens to cause large-scale losses in many of the hedge funds and private equity funds. HedgeWorld. This in turn would cause many alternative investment firms to suffer sharp reductions in their valuation and may set the stage for large-scale industry consolidation. A recent study (Schneeweis and Spurgin [1998]) found that the movements in the S&P 500 accounted for 79% of the change in returns of U. provides daily performance information on 2200 hedge funds. as indicated by the growing number of alternative investment websites on the Internet. such as December 1994 and August 1998.com.

com) Hedge Fund Center (http://www.com has a number of unique features.hedgefund. Inc. PlusFunds. the company says it will provide electronic trading in hedge fund shares on the Bermuda Stock Exchange.com) WINTER 2000 The rapid evolutionary changes in the hedge fund industry has led to an increasing number of hedge fund strategies as well as competing products.com) Alternative Investment Management Association (http://www.hedgefundcenter.com) Hedge Fund Association (http://www.3:33-42.hedgemanager. 2 1 THE JOURNAL OF ALTERNATIVE INVESTMENTS 41 .marhedge.hfr. PlusFunds. New York. For an introduction to the hedge fund universe.com. Downloaded from www.com) Plusfunds (http://www. The firm claims to have over 5. hedgebay. Fortytwo hedge funds with $20 billion in assets under management are currently participating.com expects other hedge funds will join at the request of their clients. the site provides a range of risk measures including Value-at-Risk (VaR). (http://www.plusfunds.com) RRCM. the on-line auction site. a registered broker-dealer with offices in Rye. new regulation and governmental oversight may continue to increase as the industry itself expands. and concentration analysis.hsfltd. tick by tick.aima.com) CONCLUSIONS 4 Hedge Funds.com) Hedge Fund Consistency Index (http://hedgefundindex.mfainfor. with the clearing taking place through the Bermuda Stock Exchange or directly between the buyers and sellers. Modeled after E-bay.hedgebay. Ernst & Young.hedgefundnews. exchange for hedge funds based outside the U. forward to an unauthorized user or to post electronically without Publisher permission. HedgeFund.3. SELECTED LIST OF WEBSITES WITH HEDGE FUND CONTENT Hedgebay (http://www.hedgeworld. Net Asset Values (NAV) of hedge fund shares for participating hedge funds.cta-online. Trades will be made through Tremont Securities.com) Hedge Advisors.com allows registered users to bid on and offer shares in well-known hedge funds including those of Soros and Kovner. Moreover.hedgeindex. ENDNOTES See Cerulli Associates Inc.com) CTA Online (http://www.net) Hedge Fund News (http://www.com) HedgeWorld (http://www. hedgebay.com) Managed Accounts Report (http://www.com) Hennessee Hedge Fund Advisory Group (http:/ /www. PlusFunds.magnumfund. A newly created site.com (http://www.com) Hedge Fund 411 (http://www.co.hedgeadvisors. Risk Metrics.com) Hedge Fund Research (http://www.thehfa.com) Hedge Funds Services (BVI) Ltd (http://www.eurohedge.com) HedgeScan (http://www. Advent Software.iijournals.com) Eurohedge (http://www. A powerful combination of Standard & Poor’s.com (http://www.com (http://www.com) Managed Funds Association (http://www.uk) Fund of Funds.fundoffunds.S.com) Credit Suisse First Boston/Tremont Index (http://www. and the Bermuda Stock Exchange. It provides real-time. likely maximum changes over various time frames.altvest.com) Hedge Manager Review (http://www.com) Magnum Funds (http://www.com. However. the extent of funds under management as well as increased government oversight will be determined primarily by the growth in the industry itself and its relative performance to competing products.4hedgefunds. It is illegal to make unauthorized copies of this article.hedgescan. see Crerend [1998]. Finally. the general statements in this report primarily refer to the larger and more established firms.org) Alvest (http://www.net provides qualified investors with free performance information on over 1.hedgefund411. In addition. The HedgeTrust Exchange will match buyers with sellers of offshore hedge funds over the Bermuda Stock Exchange. [1999]. Given the number and diversity of hedge funds.com) Van Hedge Fund Advisors (http://www.vanhedge.rrcm.com by Ezra Zask on 12/03/09. indicates how radically the Internet may change the alternative investment universe.hedgefnd.org) Hedge Fund Net (http://www.000 investors using its site. It also provides an interesting analysis of how the fund would have performed over previous catastrophic periods. 3 See Goldman Sachs and Frank Russell [1999].com defines itself as “the first independent marketplace” for the global hedge fund industry.000 hedge funds as well as publishing daily calculations of 33 hedge fund indexes.The Journal of Alternative Investments 2000.

Alternative Investment Management Association.” concludes that hedge fund managers should conduct stress tests of various market conditions.iijournals. Martin. Inc. Fundamentals of Hedge Fund Investing. George. Alternative Investments in the Institutional Portfolio.3. and Jerry J. 10 See Zask [2000]. 1998. Szilagyi. Kingdom Capital Management LLC. Cerulli Associates Inc. Schneeweis. Fall 1998. in a year where trading profits are 20%.000. Crerend. Hedge funds are compared with mutual funds in Rama and Szilagyi.3:33-42. use several measures of risk. Zask. 7 At present. 1998. William.. make “periodic” reports to lenders and counterparties. 1999. and Richard Spurgin. while and his colleagues compare financial advisors with institutional funds managers (see Hurley et al. 8 A critical step in the institutionalization of the hedge fund industry is the continued development of consistent performance measurement and style analysis to track the performance and strategies of hedge funds. “Multifactor Analysis of Hedge Fund. ——. Report on Alternative Investing by Tax Exempt Organizations in 1999.com by Ezra Zask on 12/03/09. Downloaded from www. including Managed Account Reports and Hedge Fund Research. et al. competing assetweighted hedge fund indexes. Derivatives Quarterly. a hedge fund managing $10 million will earn a management fee of $100.” The Journal of Alternative Investments.” This report. Inc. “Hedge Funds. 42 HEDGE FUNDS: AN INDUSTRY OVERVIEW WINTER 2000 . 5 4 REFERENCES Alternative Investments in the Institutional Portfolio. and coordinate with counterparties and regulators to develop an approach to public disclosure. Mark P. 6 Hedge funds typically charge 1% management fee on assets under management and 20% of any trading profit they make above a benchmark (typically LIBOR or a “high water mark”). Seven Quantitative Insights into Active Management. 12 See Schneeweis and Spurgin [1998]. [1999]). 1998. or are in the process of introducing. Credit Suisse First Boston and Morgan Stanley have. RR Capital Management. Market Update: Hedge Funds. 9 A group within the hedge fund community—Caxton Corporation. pp. More recently. Leverage and the Lessons of Long-Term Capital Management.” In Global Investment Risk Management. offer calculation of performance for various hedge fund groups. The Journal of Alternative Investments 2000. revenues climb to $1. With $25 million under management. 1999.See Rao and Szilagyi [1998]. Thus.25 million. especially if the stock market shows signs of weakness. It is illegal to make unauthorized copies of this article. Thomas. 1-24. Moore Capital Management. 11 Barra. only 3–5% of defined contribution plans offer long/short programs.. 2000. Managed Futures. ed. Two recent studies have found similar trends toward concentration in related investment management industries. Ezra. ibid. and Tudor Investment Corporation—has recently made the first attempt at self-regulation by propagating a set of risk management guidelines in a sponsored report. Hurley. New York: McGraw Hill. Rama. “Sound Practices for Hedge Fund Managers. New York: McGraw Hill. “Trading Risks in International Investments— Why Market-Neutral Strategies Sometimes Fail.000 and a performance fee of $400. issued as a response to the April 1999 report of the President’s Working Group on Financial Markets. Several vendors.. 1998. The Coming Evolution of the Hedge Fund Industry. forward to an unauthorized user or to post electronically without Publisher permission. 1999. 1998. Soros Fund Management LLC. which are used by hedge funds and investors as benchmarks for hedge funds to compare performance and consistency of style. Alternative Investment Management Association. Goldman Sachs and Frank Russell. The Future of Financial Advisory Business and the Delivery of Advice to the Semi-Affluent Investor. Rao. presenting a great opportunity for growth of this product. and Mutual Fund Return and Risk Characteristics.